6. Cost Allocation Techniques (Absorption, Variable costing and Service Departments)

Question 1

Absorption and Variable Costing

Answer 1

• For internal purposes , decision making is improved by treating FOH as period cost using variable costing method
• For external and tax reporting, the cost of product must contain ALL manufacturing cost using absorption method
• Under variable costing, FOH is considered as a cost on MAINTAINING CAPACITY NOT as PRODUCT COST
• The main advantage of variable costing is that income can’t be manipulated by management and marginal income concept leads to a better pricing decisions
• The monetary value of ending inventory is NEVER higher under direct costing than under absorption costing because fewer costs are capitalized under direct costing
• The difference in operating income between 2 methods is the difference in ending inventory if Beg inventory is Zero OR the difference between actual sales units and actual production units * FOH
• When everything produced during a period is sold, the 2 methods will report same operating income
• Under ABSORPTION costing, If the production EXCEEDS sales, operating income is higher than variable costing. It is misleading that absorption income statement my show decrease in profits when sales are rising and increase in profits when sales are decreasing
• Under VARIABLE costing, If the production is LESS than sales, operating income is higher than absorption income. Profit always move in the same direction as sales volume. Variable costing makes cost-volume relationship more easily apparent
• When there is NO FOH, ending inventory on the BS will be the same under 2 methods.
• Questions regarding whether a particular part should be MADE or BOUGHT can more more effective under VARIABLE costing.
• Variable costing eliminates the possible difficulties of having to explain over - under applied factory OH to higher management
• Variable costing vary directly with sales, Absorption costing vary with production levels.
• Disadvantages of variable costing:
  1) DOESN’T provide proper matching of costs and benefits
  2) It requires separating all manufacturing costs into fixed and variable

Question 2

Joints Products and By-Product

Answer 2

• Joint (common) costs are incurred UP TO the point where the product become separately identifiable, called split off point - it includes DM, DL and OH
• Separable cost at split off point is relevant when deciding the point at which a product should be sold to maximize profit
• The Primary purpose for allocating common costs to joint product is to determine the inventory cost of joint product for financial reporting.
• Available methods to allocate joint costs:
  1) Physical measure approach - using this method results in a identical unit cost for each separable cost i;e product having same quantity will take same cost share regardless of it value
  2) Market based approach: it uses entire production NOT the units sold
  a) Sales value at split off
  b) NRV method
  c) Constant gross margin % NRV method
• By-Products are relatively small in value and produced simultaneously from a common manufacturing process
• To check if by product worth processing further we must check if the NRV is Zero or Negative. if so it should be discarded as scrap
• Accounting treatment for By-Products:
  1) If material they should be capitalized in a separate
  inventory account on the amount of NRV. The treatment is justifiable when there is market ready for the By-product
  2) If immaterial they are not recognized until the time of sale.
• By product usually DON’T receive an allocation of joint costs
• The distinction between joint and by product is largely dependent on market value
• Sell or Process further decision is made based on incremental revenue gained after processing further. We must add joint cost plus cost to process further then decide

Question 3

Overhead Allocation

Answer 3

• There are 2 component under overhead, Variable and Fixed
• Vairable OH have short term planning time frame, Fixed OH have long term planning time frame.
• The 2 most appropriate factors for budgeting MOH expenses are management judgement and production volume.
• The most important criteria in accurate cost allocation is using homogeneous cost pools
• Normal rework costs incurred are charged to FOH control
• In a labor intensive industry, direct labor hours or cost is an appropriate driver. Indirect labor hours or costs are NOT appropriate drivers.
• Capital intensive industry, machine hours is appropriate cost driver.
• Usually OH is NOT allocated on the basis on units produced because of the LACK of cause and effect relationship. This method is ONLY appropriate when one product is manufactured
• Departmental OH rates are usually preferred when activities of each of the various departments in the plant are NOT homogeneous
• Annual OH application rate are used to smooth seasonal variability of OH costs.
• At the END of the period, OH is applied to WIP based on actual level of driver. Journal entry WIP (debit), OH applied (credit)
• In assigning over - under applied, Applied account is always (debit), OH control account is always (credit)

Question 4

Allocating Service Departments Cost

Answer 4

• The reason behind allocating service department costs to production departments is to determine OH rates
• Four criteria’s to allocate service department costs:
  1) Cause and effect
  2) Benefit received
  3) Fairness
  4) Ability to bear - usually unacceptable because of it’s dysfunctional effect on managerial decisions.
• The most effective way to encourage the use of service department is to keep the user away from having ability to bear and to absorb the cost as corporate expense
• Three methods for allocating service department costs:
  1) Direct method - Is the simplest, Service department costs are not allocated to each other, they are allocated to production departments only
  2) Step down method - some of the costs of services rendered by service departments are allocated to each other. One service department provides service to the 2nd service department, the 2nd can’t allocate service cost to the 1st
  3) Reciprocal method - most complex and most theoretically. Service department renders services to all service departments.
• Under direct and reciprocal method the order of allocation is irrelevant. The same amount of service department costs will be allocated to production department.
• The dual rate cost allocation is most useful when costs are separated between fixed and variable subpools.

Question 5

Rules for Calculation

Answer 5

* Absorption costing = 
Beg Inventory ( VC + FC per unit * units in beg inv )
\+ Variable MC per unit * units produced
\+ Fixed MC per unit * units produced
= Goods available for sale
- Ending Inv ( VC + FC per unit * units in ending inv )
= COGS
- Variable selling cost
- Fixed selling cost
= Operating Income

• Variable costing =
  Beg Inventory ( VC per unit * units in beg inv )
  + Variable MC per unit * units produced
  = Goods available for sale
• Ending Inv ( VC per unit * units in ending inv )
  = COGS
• Variable selling cost
• Fixed selling cost
• Fixed MC total ( FC per unit * units produced)
  = Operating Income

In both methods if the question states that volume variance (difference between sales and production exists), it should be part of goods available for sale equation = Volume variance * FC per unit

• Increase/ Decrease in Inventory = Beg - Ending Inventory
• Units produced = Increase in ending inventory + units sold
• Joint cost = Input cost (Purchase cost) + process cost
• If the question states to allocate joint costs and there was by-product, we must exclude it, example: Joint cost was 2,000, by-product value selling price * units produced minus joint cost
• In case the by-product WASN’T INVENTORIED, sales value ISN’T reduced from joint costs
• Under NRV method for cost allocation, If the question want cost per unit after distributing joint and there is separable costs, we allocate joint cost to this product then add separable cost then divide the total by number of units
• Under by-product calculation IN CASE BY-PRODUCT
  OR A PRODUCT , to check if a product worth processing further we need to do the following:
  1) Subtract price after further processing from price at split off
  2) Multiply the result of above by units produced
  3) If cost to process further is higher than above we SHOULDN’T process further
• Allocation of joint cost to product p.8-11, IMPORTANT to watch video essay
• To determine NRV for BY PRODUCT = (Selling price AFTER processing further * units produced) - Cost to process further
• Allocation of service cost to production department p. 19-21
• Predetermined application rate = Total budget OH / budget level of driver
• Applied MOH = Predetermined application rate * Actual level of driver